Some distinctive features of
Islamic banking are reaffirmed. A close linkage between the real
economy and finance obviously holds in sharing-based financing modes
but also in fixed-return modes such as murabaha.
Islamic finance can meet all the transaction needs of the market and
do so more efficiently than conventional finance because it focuses
on productivity rather than creditworthiness. By aligning
entrepreneurs' payment obligations with revenue accrual, Islamic
finance reduces instability in financial markets. The paper notes
that exchange-rate fluctuations hurt developing countries, hence the
need for regulation framed and enforced by an international agency.
Although the prohibition of interest can help cure the ills of
contemporary finance, much more must be done to create a safer, saner
financial world. Islamic economics incorporates altruism along with
self-interest: the institution of waqf is a witness to the
reality of individual behavior with a social purpose. The scope of
morally inspired economic behavior, common today as well as in the
past, needs to be broadened.

I.
Introduction

This
paper seeks to concentrate on two issues before concluding with some
observations relating to Islamic economics: Firstly, a reaffirmation
of some distinctive features of Islamic banking and finance that can
contribute to human felicity. And secondly, there are some worrisome
aspects of modern finance, especially globalized finance, which call
for attention.

II.
Distinctive Features of Islamic Finance

Islamic
finance ensures a closer linkage between real economy and finance,
the former dictating and the latter following. The linkage is
obvious in sharing-based modes of investment and financial services.
When two parties, the financier and the entrepreneur, agree that an
opportunity for creating additional value exists, they come together
to realize the gain and share it. Since economic activities are, by
definition, value-creating activities, sharing as a basis of finance
is inconceivable without economic activity. In the uncertain world
in which these activities have to be conducted, they do sometimes
fail to create additional value. There is nothing to share.
Sometimes part of the existing wealth may be destroyed-the losses
borne by capital, the entrepreneurial efforts gone unrewarded.

This
linkage between real economic activity directed toward creation of
additional wealth and financial transactions continues in case of
non-sharing Islamic modes of finance such as murabaha
(cost-plus), salam and istisnac(prepaid orders) and ijara (leasing). These deals, which
are being used by contemporary Islamic banks to secure predetermined
returns on their investments, are possible only when some real
economic activity is involved. There have to be some goods and
services to be objects of murabaha, salam,
istisnac, and ijara. The demand and
supply of these goods and services whose exchange is "financed"
through the above mentioned contracts ensures that financial activity
is the servant not the master of real economic activity.

Prohibition
of "interest" has closed the door on exchange of more money
for less money, even when a period of time intervenes. Stratagems
(Hiyal) securing the same goal by bringing in a commodity in a
nominal way e.g. ina, tawarruq or baycal-wafa are rejected as impermissible.

There
remains the gray area of exchange between different monies, i.e.
selling one currency for another. Islamic economic research in this
area has yet to catch up with the times. I do not have any opinions
to pronounce save noting that it is a necessary economic activity
facilitating exchange of goods and services across borders. Fear of
making financial transactions "profitable" without there
being any link whatsoever with exchange of real goods and services
makes many Muslim scholars opt for the strictest interpretation of
the relevant rules. But that carries the danger of restricting what
may be really necessary. The challenge of finding the golden mean
remains.

III.
The Viability of Islamic Finance

It
has been demonstrated that all market activities can be financed by
using the various Islamic modes, such as musharaka,
mudaraba, murabaha, salam,
istisnac, and ijara. No stratagems are
needed. Financing consumption needs that fall outside the market
(there being no prospective income to pay from out of) requires
humanitarian solutions in the voluntary-cooperative sector or under a
state sponsored safety net. Financing government deficits has also
been shown to be quite feasible.i
How far it is desirable to run deficits, how long and what for, are
however issues far beyond the scope of "finance."

We
have been arguing that interest-free Islamic modes of finance can
replace the conventional interest based finance with certain added
advantages. By synchronizing entrepreneurial payment obligations and
accrual of revenues, sharing-based modes of finance remove a major
source of instability from freely functioning markets.ii
Also by linking financial intermediaries' returns to the actual
revenue of the fund users, allocation of funds to invest is
redirected to projects expected to produce more value than their
alternatives.

Even
though the predominance of non-sharing modes of finance in the
current practice of Islamic banking dilutes these advantages, the
Islamic system would score far better than any system that permits
exchange of more money for less money. Part of the reason is the
vast opportunities of exchange that this permission opens bypassing
the real economy which is focussed on exchange of goods and services
with one another, money serving as a means of such exchange.
Exchange of money for money degenerates into a game of chance in
which people indulge to try their luck, little benefit flowing to the
production of goods and services which exchange is supposed to
promote. Prohibition of interest is directed at restoring money to
its essential functions, which certainly do not include a means for
gambling.

IV.
Beyond an Interest-free Economy

We
now turn to the worrisome aspects of contemporary financial markets.
As already noted, prohibition of interest would go a long way in
improving the situation. You exchange money either for goods and
services, or for money or for debt. In the Islamic framework we have
no problems with the first, the second, exchange of money for money
is severely constrained, and the third is almost eliminated. Islamic
law allows cash for debt only at par,iii
which leaves no room for a "market" in which debt could be
sold for cash. It also allows exchange of debt for debt at par and
with further restrictions. Again the possibility of a "market"
for debt is slender. There would, of course, be a market for common
stock, ijara (lease) certificate,iv
and financial papers based on salam or istisnac.v
But, despite their presence, the scope for speculation in an Islamic
framework would be far less than witnessed at the present.

The
disturbing features of contemporary finance, which would remain
unaffected by the prohibition of interest, restrains on the money
market and the demise of the market for debt, are the following.

The possibility of
massive capital movements into and out of a country, which has
destabilizing, effects, especially for small economies.

Wide exchange rate
fluctuation, to the great disadvantage of small developing countries
dependent on foreign trade.

Social, cultural and
political aspects of financial globalization and multinational
corporations (MNCs) dominating the market. This is especially
worrisome to developing countries in Africa and Asia that do not
share the sociocultural background of the regions where the MNCs are
based. These countries also lack sophisticated bureaucracies,
mature politicians and efficient media, which could be a guard
against the possible undesirable role of MNCs.

We
now take up these issues one by one. In an Islamic framework the
influx of foreign capital in a country would hardly be in the form of
loans, as they would earn no returns. Foreign capital would come
either in partnership with local capital and/or enterprise, in which
case it would commit itself for medium or long run, or as price paid
for common stock, in which case it would be short term. It could
also come through a murabaha contract in which case the
date for its possible exit with returns is determined from now.
Capital invested in financial papers based on ijara, salam,
or istisnac can, however, make an exit at
will. In sum, we have two kinds of foreign capital, the long-term
partnership and murabaha based capital which is subject
to a predetermined schedule so far as its withdrawal is concerned,
and the short-term capital invested in the market for common stock
and other financial papers. It is the second kind which calls for
attention as it can leave the country at will. The usual solution is
to impose some kind of discipline so that the destabilizing effects
of withdrawals of foreign capital are minimized.

Some
kind of regulation is necessary. Several ideas, including those of
James Tobin are relevant.vi
The crucial thing, however, is to shift the focus from ad hoc
individual initiatives and policies to some kind of international
understanding. There is a need for an international agency, maybe
part of the UN system, to be set up to engineer the needed regulation
and protect the small and the weak from actions emanating from
profit-driven investment decisions (and speculation) oblivious of the
social political and ethical dimensions of such decisions. The
conscience of the world community must take charge where the market
fails to give due weight to mankind's larger interests (i.e.
interest other than enrichment of capital owners).

The
post World War II fixed exchange rate regime collapsed in 1971
because of the inability of the United States of America to continue
honoring its commitment to a certain gold value of the dollar. A
return to gold standard now seems neither feasible nor desirable.
But the type of exchange rate fluctuations experienced by Southeast
Asian economies in 1997-98 is simply a killer. It demonstrated for
all not only the dangers of freely floating exchange rates but also
much more that needs correction, so succinctly indicated in the
following quote from the Human Development Report 1999.

"When the market goes too
far in dominating social and political outcomes, the opportunities
and rewards of globalization spread unequally and
inequitably-concentrating power and wealth in a select group of
people, nations and corporations, marginalizing the others. When the
market gets out of hand, the instabilities show up in boom and bust
economies as in the financial crisis in East Asia and its worldwide
repercussions, cutting global output by an estimated $2 trillion in
1998-2000. When the profit motives of market players get out of
hand, they challenge people's ethics-and sacrifice respect for
justice and human rights."vii

Some
degree of exchange rate stability must be ensured if the small and
the weak have to coexist on planet earth with the big and the
strong-as they must. It is generally recognized that this
necessitates some regulation of capital flows, but the timing and
modalities of such regulation are not clear. In the absence of an
agency especially designed for this purpose, most favor the IMF and
the World Bank to take up this role.

If
taken up in earnest there is a need to set limits within which only
supply and demand are allowed to determine exchange rates. That in
its turn calls for manipulating supply or demand, as the case may be,
when needed. Only an agency with almost unlimited resources (in
respective currencies) can play this role (of the "lender"
of last resort). Does this mean the power to create money? Maybe
yes.

It
can now be seen how difficult it would be for the IMF and the World
Bank, under their current constitutions, to take up this task. A new
international understanding is necessary.

The
clock of globalized finance cannot be turned back. It need not be.
It is good even for small developing countries that international
financial giants-banks, mutual funds, investment companies-can find
it profitable to pour in resources to exploit the vast opportunities
for wealth creation these countries in Africa and Asia offer. But
there are some problems-psychological, cultural, and political.

Smart
briefcase holding (mostly Western) representatives of the MNCs,
stepping out of five star hotels remind onlookers of the colonial
days. How to change that perception? Employing local boys helps.
Broadening the vision of MNCs to include the social dimension in
their profit making activities will help more.viii

This
goes hand in hand with encouraging tourism and helping local
entrepreneurs to invest in developing resorts, which could attract
foreign tourists and earn hard currencies. Add dish antennae,
casinos, and nightclubs, and you have a scenario ripe for breeding
misgivings leading to anger among the "natives." They
visualize a cultural onslaught and feel being targeted with hegemonic
designs of the western culture and fear losing their age-old
traditions.

Sovereign
states are supposed to take care of themselves. Those who feel the
need enter into alliances for defending their boundaries, even enlist
foreign cooperation in maintaining internal security. Vulnerability
to the manipulations of MNCs and financial giants is however a new
kind of danger, which the traditional modes of "defense"
fail to handle. Primitive administrative structures, inexperienced
political elite, largely illiterate electorate-that is not a position
very helpful in dealing with the new danger. Protection is needed
which can come only in the form of counseling and, if needed,
intervention, by some international agency, preferably working under
the UN system.

These
observations are offered here with two ends in view.

First,
it is to reassure all concerned that the Islamic economists share the
anxiety justifiably caused by the current happenings in the financial
markets in particular and in the economic aspect of living in
general. They too share the search of a better way for managing our
affairs.

Second,
it is to shake out of their naivete those sympathizers of Islamic
economics who might presume that abolition of interest takes care of
all the current problems in finance and economics. There is a need
to go beyond that necessary but not sufficient step in an Islamic
reconstruction of man's economy.

V.
Premises and Promises of Islamic Economics

More
than any thing else, Islamic banking and finance, a sub-culture of
Islamic economics, has been a quest for justice and morality into
"the ordinary business of life." Justice and morality
cannot, however, be all encapsulated into laws and regulations,
especially when it comes to protecting the small and weak from the
big and strong. Some behavioral changes are called for. Justice and
morality have to penetrate the behavior of all economic agents,
including the decision-makers at the national and international
level, so that all can live together in peace and harmony. Has
Islamic economics something to offer in making this possible?

At
the heart of the Islamic economic culture lies care for others as a
force tempering man's innate selfishness. In sharp contrast to
neoclassical economics, which dominated the scene during the
twentieth century, Islamic economics brings the social dimension of
living into focus, thus downsizing individualism. It also recognizes
morality as a potential motor of action and overseer of
self-interest. The former, the social dimension, is compulsory;
economic analysis can ignore it only to its peril. The latter,
ethical action, is a potentiality in the realization of which
civilizations have had different records. But no human society has
been devoid of the moral dimension. Thus, ignoring it can never be
justified.

As
regards, Islamic economics the moral dimension is its raison d'être.
As the literature shows, the last fifty years have shown several
attempts to analyze morally informed human behavior in production,
consumption, and exchange.ix

Nothing
captures the distinguishing features of Islamic economics noted above
i.e. a care for others, as does the institution of waqf
(charitable endowments). Unlike the Zakat levy and the
prohibition of interest, there is no legal force behind waqf.
No Muslim is under compulsion to create a waqf under any
circumstances whatsoever. And yet this institution emerged right
during the days of the Prophet (peace be upon him), and continued to
grow through out Islamic history. This giving away of private
property for social purposes must have had ripple effects on the
economies in which it took place, but the phenomenon has yet to
attract the attention of analysts other than historians.

The
other pillar of capitalism, along with private property, is free
enterprise. Here social and moral dimension shows up into priorities
in production and consumption and self imposed limits on profit
making. The literature of hisbax
(accountability) partly captures this, as do the economic writing of
Ibn Taymiyyah, al Ghazzali, Muhammad Ibn al Hasan al Shayhani and Abu
Yusuf-in the reverse chronological order.xi
Recent attempts to study Muslim economic agents under influence of
Islamic norms and values have been very few,xii
reflecting the continued domination of neoclassical economics. But
we do have enough evidence on the reality of ethical economic
behaviorxiii
in the contemporary societies in East and West to justify attempts to
broaden its scope and capture new areas. That is the need of the
hour.

*
Professor of Economics, Center for Research in Islamic Economics,
King Abdulaziz University, Jeddah, Saudi Arabia. This paper
originally appeared in the Proceedings of the Third Harvard
University Forum on Islamic Finance, published by the Center for
Middle Eastern Studies, Harvard University, Cambridge, Mass., 2000.

vi
Tobin, James. "Financial Globalization: Can National
Currencies Survive?" in Annual World Bank Conference
on Development Economics, 1998. Washington: The World Bank,
1999. pp. 63-75.

vii
The United Nations Development Program. Human Development Report
1999. New Delhi: Oxford University Press, 1999. p. 2.

viii
"Multinational corporations influence the lives and welfare of
billions of people, yet their accountability is limited to their
shareholders, with their influence on national and international
policy kept behind the scenes. If they were brought into the
structure of global governance their position would become more
transparent and their social responsibility subject to greater
public accountability." Human Development Report 1999.
New Delhi: Oxford University Press, 1999. p. 12.

x
Ziadeh, Nicloa. Al-Hisba and al-Muhtasib
in Islam: Old Texts Collected and Edited with an
Introduction. Beirut: Catholic Press, 1962.

xi
Siddiqi, M.N. Recent Works on the History of Economic Thought in
Islam. Jeddah: International Center for Research in Islamic
Economics, 1982. Also Siddiqi, M.N. and S.M. Ghazanfar. "Early
Medieval Arab-Islamic Economic Thought: Abu Yusuf's Economics"
in a forthcoming issue of History of Political Economy;
Ghazanfar, S.M. and A.A. Islahi. Economic Thought of al Ghazali.
Jeddah: Center for Research in Islamic Economics, 1998; and Islahi,
A.A. Economic Concepts of Ibn Taymiyyah. Leicester: The
Islamic Foundation, 1988.

xii
El Ashkar, Ahmad A. On the Islamic Theory of Economic Behavior:
An Empirical Study in a Non-Muslim Country. Durham: Center for
Middle Eastern and Islamic Studies, University of Durham, 1986.
Also by the same author, see Islamic Business Enterprise.
London: Croom & Helm, 1987.

Reproduced with gratitude from
"Proceedings of the Third Harvard University Forum on Islamic Finance:
Local Challenges, Global Opportunities" Harvard University,
Cambridge, Massachusetts, October 1, 1999. pp.49-53